How Fund Investors Can Minimize Taxes

NEW YORK ( TheStreet) -- Fund investors may be cheering the market rally, but higher stock prices come with a painful side effect: bigger tax bills.

If stocks hold onto their gains, plenty of investors in taxable accounts can expect to lose more than 15% of their returns to the tax man.

To avoid paying Washington, financial advisers have long recommended a variety of strategies, such as investing in exchange-traded funds or buying mutual funds with low portfolio turnovers.

But many of the conventional tax strategies can fail. Instead of following rules of thumb, investors should keep a close eye on how much funds actually return after taxes. The aim should be to buy funds that have delivered strong aftertax returns in the past and seem likely to continue performing well in the future.

Consider ETFs. In theory, ETFs should be more tax efficient than competing mutual funds, but in the real world the results vary.

To appreciate the complexity of finding the most tax-efficient choice, compare the Vanguard 500 Index ( VFINX) -- the largest S&P 500 mutual fund -- and two popular ETFs: the iShares S&P 500 ( IVV) and SPDR S&P 500 ( SPY).

All three funds track the S&P 500, and all returned about 3.2% annually during the past 10 years, according to Morningstar. But on an aftertax basis, the mutual fund was superior.

After taxes, investors in the top tax bracket would have an annualized return of 2.83% in the Vanguard fund. The iShares fund returned 2.69% after taxes, while the SPDR returned 2.62%.

Why did the old-fashioned mutual fund outdo the ETFs?

Vanguard uses a strategy that involves separating a portfolio into tax lots and selling stocks to book losses.

Say the fund buys a stock at $10. In subsequent weeks the shares rise, and the portfolio managers buy more of the same stock at $11 and $12.

Now the stock drops back to $11. If the fund needs to provide cash to departing shareholders, the portfolio managers must sell stocks.

To limit tax bills, the managers sell the group of stock that was purchased at $12. That will result in a capital loss that can be used to offset gains and help make the fund tax efficient.

Any fund manager can engage in tax-loss selling, but the process may be more difficult for ETFs.

Say an institutional investor wants to redeem $10 million worth of an ETF. Instead of selling individual shares of stock and then giving cash to the investor, the ETF portfolio manager gives the stock to the institutional seller in exchange for shares of the fund. For the fund there is no stock sale -- and no capital losses that can offset gains.

The ETF system may provide a tax advantage in bull markets, when big capital gains can result in steep tax bills. But in the downturns of the past decade, Vanguard's tax-loss selling may have provided an edge.

Make no mistake, ETFs can be extremely tax efficient, and many ETFs are more efficient than comparable mutual funds. But there are plenty of exceptions to the rule.

Just as they preach the virtues of ETFs, many advisers also tell clients to prefer funds with low turnover. According to the theory, funds that rarely sell their stocks should not generate many capital gains tax bills.

In practice, funds that turn over a small percentage of their portfolios annually are not necessarily the most tax efficient.

Compare Franklin Rising Dividends ( FRDPX), which has a turnover of 6%, and Janus Contrarian ( JSVAX), which has a turnover of 104%.

Both funds are top performers in the large blend category. During the past 10 years, Janus returned 6.7% annually and outdid 96% of its peers, while Franklin returned 6.5%.

But during the past decade, Janus has been more tax efficient. After taxes, Janus returned 6.2%, about a percentage point better than Franklin.

The reason for the tax variance must be connected to the investing styles of the two funds. Franklin sticks with staid, dividend-paying blue-chips such as Procter & Gamble ( PG) and Wal-Mart Stores ( WMT). Janus is a volatile fund, picking unloved stocks and sometimes investing in the emerging markets.

Franklin's blue-chips generate rich dividend income, which is taxable. In contrast, Janus is more tax efficient because it pays only skimpy dividends. While Franklin is a steady performer, Janus tends to soar in bull markets and sink in downturns.

During the collapse of 2008, Franklin lost 27.2% and Janus declined 48.1%. The big losses of Janus may have been painful, but they could offset the sizable gains the fund recorded in the recovery of 2009.

Because of the tax losses, the Janus fund may be tax efficient. But tax efficiency is hardly a reason to prefer Janus over Franklin.

Instead, investors who seek to minimize taxes should take a broad view of each fund and not cling to rules of thumb that can sometimes provide misleading guidance.